Government’s Effort To Stop Soaring Mortgage Defaults A Failure

The record high rate of mortgage delinquencies and foreclosures remains the banking industry’s biggest obstacle towards financial recovery. The horrific statistics for the first quarter on mortgage defaults provides little reason to believe that the housing crisis will end anytime soon.

The delinquency rate for all mortgages on one to four residential units was 10%

4.6% of all homes are in the process of foreclosure

More than one out of every eight or 15% of all American homes with a mortgage are either in default or in the foreclosure process

In May, 94,000 homeowners lost their homes to foreclosure, for an annualized rate of 1.1 million homes

The percentage of home mortgages that are 90 days or more past due or in the process of foreclosure is 9.5%

Almost 25% of homeowners owe mortgage debt exceeding the value of the home

Banks and mortgage investors are now sitting on an estimated inventory of 550,000 homes that have been repossessed through foreclosure and need to be sold into a weak market

In an effort to stabilize the housing market and prevent catastrophic losses to banks, the government instituted a variety of programs designed to help struggling homeowners avoid foreclosure. The most prominent government program instituted was the Home Affordable Modification Program (HAMP). HAMP has been roundly criticized by many observers as being ineffectual, keeping homeowners in homes that they cannot possibly afford long term and prolonging the housing crisis.

One prominent industry expert, Edward Pinto, testified today to the Oversight and Government Reform Committee of the U.S. House as to why HAMP is a failure. Mr. Pinto was Fannie Mae’s chief credit officer from 1987 to 1989 and is an expert in credit risk methodology and loan performance metrics.

Portions of Mr Pinto’s testimony follow, including his opening remarks which pinpoint the reason for the current housing and banking crisis – loans made with poor underwriting and low or zero down payments to borrowers who could not possibly afford the mortgage payments.

Government initiatives dating back to the early- to mid-1990s mandated looser underwriting standards and resulted in trillions upon trillions of dollars of weak loans being originated, with Fannie and Freddie playing a leading role. This is best demonstrated by the policy initiative relating to reducing and eventually largely eliminating downpayments – a policy embodied in HUD’s 1995 National Homeownership Strategy. In 1990 only about 5% of home purchase loans had a downpayment of less than 5% and virtually all were insured by FHA or VA. By 2006 the National Association of Realtors reported for first time home buyers “nearly half of [such buyers] nationwide put down no money.” It is this legacy of weak loans that has made qualifying at-risk loans for modifications so difficult.

While some project a permanent modification re-default rate of over 50%, I expect a lower, but still high rate of 40%. Why so high? First, most permanent modifications are on loans with mortgage balances well in excess of current home values. Second, borrowers obtaining a permanent modification through May 2010 had a median total debt-to-income ratio of 64%.7 A total debt to income ratio of 40% would be considered high on a loan not at risk. This leaves little money for food, clothing, taxes, and other expenses. As a result these borrowers are a worn out furnace or roof replacement away from re-default.

Turning to “alternative modifications”, we are at risk of repeating the same policy mistake that got us into this mess. Just as the government’s calls for looser lending standards and HUD’s “best practices’ policies made it difficult to turn down
unqualified borrowers for a loan, HAMP and its off-spring are evolving into programs aimed at approving a modification no matter the financial cost or sustainability.

Treasury’s many missteps with HAMP have had other repercussions.

It has encouraged strategic defaults – homeowners are willing to default when the value of a mortgage exceeds the value of their house, even if they can afford to pay their mortgage.

Amherst Securities’s research found that HAMP encourages such defaults because: “[T]hey can live in their house rent free during the time it takes to establish if they qualify for a HAMP mod. And if they qualify, they can stay in the program for at least 3 months, even if they do not make a single payment.”

Researchers at the University of Chicago and Northwestern University found that:

“[In Quarter 1, 2010], more homeowners voluntarily defaulted on their mortgages and chose to walk away from their homes than the total number of mortgages permanently modified to date under the Administration’s year-old
Home Affordable Modification Program (HAMP). The percentage of foreclosures that were perceived to be strategic was 31 percent in March 2010, [up dramatically] compared to 22 percent in March 2009 [when HAMP started]….With more and more homeowners believing that lenders are failing to pursue those who default on their mortgages, there is a risk that a growing number of homeowners will walk away from their homes even if they can afford monthly payments.”

HAMP has also slowed down foreclosure processes, pushing the level of heightened foreclosure activity out to 2013 or 2014 and likely extending the period for the market to correction.

HAMP has also slowed down foreclosure processes, pushing the level of heightened foreclosure activity out to 2013 or 2014 and likely extending the period for the market to correction.